Venice G20 #2: sustainability rankings and the risk of greenwashing

Professors Monica Billio, Loriana Pelizzon and Stefano Battiston

On 6th July 2021, the European Commission announced new measures on sustainable finance and put forward a new strategy to make the EU's financial system more sustainable. The 'Strategy for Financing the Transition to a Sustainable Economy' identifies the need to accelerate the green transition including the potential of finance by making sustainable finance more inclusive for SMEs and citizens and the financial system more resilient to sustainability risks.

Sustainable finance and the green transition are on the agenda of the Finance Ministers and Governors of the Central Banks meeting in Venice from 8 to 11 July 2021. There is an urgent need for a better understanding to avoid greenwashing and to support SMEs access to green finance.

These are the topics addressed in this article by Stefano BattistonMonica Billio, and Loriana Pelizzon, professors at the Department of Economics of Ca' Foscari University of Venice.

The third and final article in the series, Venice G20 #3: climate and finance, will be published soon.

One of the main challenges for the scaling up of sustainable investments is the need for transparent and standardised information about companies’ sustainability profile, performance and risk exposure.

This has led to the creation of sustainability and ESG (Environmental, Social and Governance) indices, which have gained considerable importance in the market, even during the COVID-19 pandemic crisis, becoming a mainstream form of investment. 

Measuring the sustainability of a firm is not a straightforward task. Sustainability comprises aspects such as environmental impact, social engagement, and good governance. Challenges in assessing these aspects have significant repercussions on the real economy, as millions of euros in savings in the investment industry could be misdirected, due to the absence of a reliable form of assessment of sustainability criteria.

The term ESG was officially introduced in 2004 by the United Nations Global Compact Initiative in the report "Who Cares Wins". The term is intended to set the ambitious goal of bringing together three of the main pillars of ethical finance: the Environmental, Social, and Governance pillars. 

In the past decade, growing concerns about global warming and the implications of the 2008 financial crisis have led to a significant increase in investor preferences for sustainable investment.

ESG-related investment products have seen a significant increase in volume and are not any longer a niche investment practice today. This market segment is likely to continue to increase, yet in a more orderly way, following regulations such as the European Commission's EU Sustainable Finance Agenda, the Next Generation EU plan, and the EU Recovery and Resilience Facility with at least 37% of funds dedicated to the transition to a greener economy.

Today, the majority of the world's asset managers are signatories to the United Nations Principles for Responsible Investment (PRI), representing around USD 100 trillion in assets under management. However, investors, managers and policymakers need a deeper understanding of the inherent peculiarities of this new and rapidly increasing ESG financial sector, which is not yet sufficiently and properly regulated. Moreover, measures for taming moral hazard and greenwashing need to be in place.  

In the aftermath of the Paris Agreement of 2015, climate change has become a key aspect of sustainable finance and the Network for Greening the Financial System — the global platform of financial supervisors — has been encouraging banks and investors to assess their climate-related financial risk. The Environmental dimension of ESG includes a number of subdimensions that are related in particular to climate change mitigation, for instance assessing whether firms have a policy to reduce their emissions and explicit targets, as well as their level of reliance on fossil fuels. These dimensions are often referred to by practitioners as components of ESG risks. However, it is important to highlight that these ESG dimensions provide only limited information to assess quantitatively climate-related financial risks. Indeed, many of these dimensions are qualitative in nature and self-reported. Moreover, most of them are backward looking, while a correct assessment of risk would require forward-looking information. In particular, ESG data does not specify how well firms will be prepared to face the low-carbon transition in the next decade under the different climate mitigation scenarios elaborated by financial supervisors and scientists.

Fuelled primarily by investor interest, the market for ESG data and ratings is developing quickly, but in a very disorganised way, because of the difficulties in measuring all the ESG dimensions.

A recent analysis by Ca’ Foscari researchers, Inside the ESG Ratings: (Dis)agreement and Performance, investigates the calculation methodology, the metrics used and the main differences among the numerous ESG rating agencies operating in the market today. The study shows that the lack of agreed definitions of what exactly represents the ESG dimensions, and what does not, has led agencies to use different measurement approaches. As a result, the same company can have highly divergent ESG ratings depending on which agency has rated it. This has strong implications both on the operational side, i.e. on the identification of reliable benchmarks, and in terms of returns. Disagreement over the ESG ratings provided by rating agencies scatters the effect of investors' ESG preferences on financial asset prices, to the extent that even when there is general agreement, this has no impact on financial performance. 

In addition, following market demands, ESG rating agencies find themselves forced to frequently change their methodology, contributing further to the ESG measurement confusion. Ca’ Foscari’s researchers highlight the effects of such methodological changes in another paper, The Salience of ESG Ratings for Stock Pricing: Evidence From (Potentially) Confused Investors, and show that changes in ESG ratings induced by changes in methodology (and not related to potential fundamental changes in the sustainability of the firm) exert a transitory pressure on stock prices. The analysis shows that retail investors are particularly sensitive to changes in ESG ratings and divest from stocks they believe to be downgraded, moving to stocks with increased ratings. However, since these ESG rating changes have no tangible economic basis, short sellers act as arbitrageurs or informed investors and, by acting as counterparties to retail investors, literally gain from the "confusion" that ESG rating agencies create on the stock market.

Navigating in such a heterogeneous and opaque market segment carries considerable risks. One of the major risks is misleading investors to an inefficient allocation of their resources. In fact, on the one hand, disagreement on ESG scores across data providers could reflect differences in the underlying criteria used, which could possibly cater for heterogeneous preferences (e.g. some rating agencies could have stronger relative attention to certain sustainability themes over others). On the other hand, disagreement and confusion on scores could make greenwashing more difficult to detect and thus more tempting.  

This phenomenon is particularly relevant when assessing the efforts that firms make or claim to make in order to be aligned with climate targets and has been investigated by Ca’ Foscari researchers, Assessing Forward-Looking Climate Risks in Financial Portfolios: A Science-Based Approach for Investors and Supervisors. Two factors increase the risk of greenwashing here. The first factor is the intrinsic uncertainty of how high versus low carbon economic activities will fare in the future. The scenarios elaborated by financial supervisors describe economic trajectories under different scenarios, but leave freedom to investors to assess how these scenarios will impact on financial performances of firms and securities. The second factor is related to the assessment of both the contribution of firms to the low-carbon transition efforts and their exposure to the risks associated with the transition requiring sector-specific Key Performance Indicators. While it would be possible to collect and consolidate these indicators for a large portion of firms, their disclosure by firms, e.g. in annual reports, is currently absent or partial and often hard to compare. As a result, it can be difficult for investors to assess how much real effort in climate-aligned capital expenditures and strategy there is behind firms’ marketing campaigns for climate change mitigation.

Written by Stefano BattistonMonica Billio, and Loriana Pelizzon, Professors at the Department of Economics of Ca’ Foscari University of Venice.

Ca’ Foscari is highly engaged on the topic thanks to two important research projects funded by the European Investment Bank Institute (EIBURS Project and the European Commission (TranspArEEnS – Mainstreaming Transparent Assessment of Energy Efficiency in ESG Ratings), both devoted to support small and medium enterprises in their disclosure of ESG dimensions and thus to  improve their access to long-term finance, especially for energy efficiency.